Decision tree problem:
When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2021, and the equipment necessary for producing the containers was being sold for $750K. Each year, this cost is expected to increase by 30%. The useful life of the equipment and the project is 6 years. Mr. Johnson estimated that during a recovery year, the project will generate net cash flows of $500K per year, while during a recessionary year, the project will lose money, with an expected net cash flow of $-100K per year. Because the economy suffered a significant decline during the year, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that 2022 provide certain information about the likelihood of recovery. At this point, in 2021, the likelihood of 2022 being a recovery year is estimated at 45% and the likelihood of 2022 being a recession year is estimated at 55%. If 2022 is a recovery year, the likelihood that recovery continues in 2023 and all subsequent years is 80%, and the likelihood of these subsequent years being recessionary years is 20%. If recession continues in 2022, the likelihood that 2023 and all subsequent years will be recovery years is 30%, and the likelihood of these subsequent years being recessionary is 70%. In 2023, the market gets resolved, and whatever state of the economy was in 2023 will continue the foreseeable future with certainty. The management identified that they need to invest in the project in the next three years, or abandon it forever. That is, they were considering undertaking the investment in 2021, 2022, or 2023. Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%. Also assume that the firm can shut down the project any time at a one-time cost of $20K. What strategy with respect to this investment will generate the highest value for the firm? In other words, when should the firm invest and under what circumstances? To answer this question, a) evaluate the NPV of investing in 2021, in 2022, and in 2023, and b) carefully think about how you can combine the information obtained in these estimations to identify the most value-increasing strategy. When preparing capital budgeting analysis for a new project, Chris Johnson, a chief financial officer at BT Industries, faced a dilemma. The project involved a production of new type of shipping containers, which were significantly more durable and had a considerably longer useful life compared to conventional containers used in the industry. The year was 2021, and the equipment necessary for producing the containers was being sold for $750K. Each year, this cost is expected to increase by 30%. The useful life of the equipment and the project is 6 years. Mr. Johnson estimated that during a recovery year, the project will generate net cash flows of $500K per year, while during a recessionary year, the project will lose money, with an expected net cash flow of $-100K per year. Because the economy suffered a significant decline during the year, there was uncertainty about the economy in general, and, very much affected by the economy, the demand for shipping and containers. Market analysts predicted that 2022 provide certain information about the likelihood of recovery. At this point, in 2021, the likelihood of 2022 being a recovery year is estimated at 45% and the likelihood of 2022 being a recession year is estimated at 55%. If 2022 is a recovery year, the likelihood that recovery continues in 2023 and all subsequent years is 80%, and the likelihood of these subsequent years being recessionary years is 20%. If recession continues in 2022, the likelihood that 2023 and all subsequent years will be recovery years is 30%, and the likelihood of these subsequent years being recessionary is 70%. In 2023, the market gets resolved, and whatever state of the economy was in 2023 will continue the foreseeable future with certainty. The management identified that they need to invest in the project in the next three years, or abandon it forever. That is, they were considering undertaking the investment in 2021, 2022, or 2023. Mr. Johnson has estimated that the WACC for the company in certain times has been 10%. Assume that the project has no tax implications, i.e. the tax rate of 0%. Also assume that the firm can shut down the project any time at a one-time cost of $20K. What strategy with respect to this investment will generate the highest value for the firm? In other words, when should the firm invest and under what circumstances? To answer this question, a) evaluate the NPV of investing in 2021, in 2022, and in 2023, and b) carefully think about how you can combine the information obtained in these estimations to identify the most value-increasing strategy
